Monday, October 10, 2011

Re-writing history

By the way, in the middle of the several comments praising the winners of the Sveriges Riksbank Prize in Economics there will be a lot of misplaced acclaim. Here is one example from the Huffington Post:

"Sargent famously weighed in on the fight against inflation in the early 1980s. Many economists believed it would take years of high interest rates to bring inflation down. But Sargent believed that inflation could be tamed much faster if the Federal Reserve acted enough to break the public's expectations that prices would continue to rise rapidly. That is basically what happened: Then-Fed Chairman Paul Volcker raised interest rates so quickly and so much that inflation expectations were shattered."

So now, if you believe this report, Sargent and Lucas were right about the costless disinflation of the 1980s. Forget that disinflation had to do with falling commodity prices, caused by the hike in interest rates, and with the weakening of the labor force, which faced what was, in the US up to that point, the worse recession since the Great Depression. Unemployment in the US reached 11%, but it was inflationary expectations that mattered. And the Huff Post is a progressive site, isn't it?!

5 comments:

from a circuitist or cartalist (ala your paper with david) prespective, what exactly is the mechanism for very high interest rates to break inflation? is it the large capital losses discouraging new investment (from firms not turned into insolvent control frauds like the S&Ls)? is it the large capital losses that encouraged fiscal entrenchment from firms in the form of layoffs? is it the capital losses taken on commodities? is it all of the above?

Circuitist is one thing, Cartalist another, and endogenous money is a third distinctive thing. Even if I agree with some elements of the circuit school, I'm far from being part of that school. [At some point at least, see the intro to my edited book, Credit, Interest Rates and the Open Economy, a member of the school suggests that they believe that the spending multiplier is always one; something that to me makes no sense]. But replying to your question how I see it is this way. The high rates of interest of the Volcker era had a brutal impact on all debtors, and send developing countries into default. In the developed world the fall in consumption, and the following recession (high unemployment), together with the ascendancy of the conservative movement (e.g. Reagan's treatment of air controllers) reduced the bargaining power of workers. The fall in global demand also reversed the pressures on oil and other commodity markets, which also reduced the pressures on the cost side. Investment is always a reaction to the level of activity (it's just the accelerator). High interest rates do have an indirect effect on costs, and that is how they affect inflation, not directly through demand, in particular because inflation was cost-push in the 1970s. My paper on Inflation in Arestis and Sawyer's Handbook of Alternative Monetary Economics provides a more detailed view. A Working Paper version is here http://www.econ.utah.edu/activities/papers/2005_14.pdf

It is important to make a distinction between Sims and Sargent. Sargent is a deductive rational expectations guy. Sims is an empiricist first, an inductive person that uses VARs. He actually revived Keynes' thinking among the mainstream by showing how external shocks can not be "expected" and can have a significant impact on AD. He is also seen as the leading insider critic of DSGE models.

He could not possibly be clearer about the "incredible" restrictions that models often impose, and proposed a way forward, the VAR in its many forms.

That method has evolved to the point where, for example, good econometricians can recast a DSGE model in VAR form and see if it survives the data. Often they don't, a recent example being Peter Irelands DSGE so soundly rejected by Katarina Juselius.

The rub is in the qualifier good. This is not easy stuff to do correctly. But its power is worth the sweat.

Sims has been homaged over his prize by Mark Thoma here http://economistsview.typepad.com/economistsview/2011/10/christopher-sims-and-causality-testing.html, and by Jim Hamilton, the time series bible author here http://www.econbrowser.com/archives/2011/10/sargent_and_sim.html.

(Can't see where to embed a link in a comment)

A very favorite story is when Sims, Robert Litterman, and Thomas Doan, all either at the Minneapolis Fed or U of Minnesota in the 80's, "took on" their big models with a small VAR and outforecast them by a bunch.

They soon left, maybe excommunicated? But Sims and Litterman at least landed on their feet...Litterman just retired as head statistician at Goldman Sachs.

So the Sims triumph validates a reality first approach, meaning data before theory, and with the tools we now have and careful work, this method will become ever more influential in applied macro.

Sims has also contributed to Bayesian approaches to macro modeling.

I totally miss the logic of the pairing with Sargent, but such is academic politics.